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Soaring energy bills over the past 18 months have hit British household budgets hard, fuelling record double-digit inflation and a cost of living crisis.
The surge in energy prices as Russia cut natural gas supplies to Europe in the run-up to its full-scale invasion of Ukraine has now eased and consumers will start to feel some relief in July when that feeds through into lower energy bills.
Yet at the end of last month, Jonathan Brearley, head of Ofgem, warned households not to expect bills to return to pre-crisis levels until at least the middle of the decade with analysts warning high prices are likely to persist further out.
The Financial Times explores the reasons behind regulator’s warning and what is likely to happen to energy bills in the longer-term.
What has happened so far?
For years, wholesale gas prices in Britain were steady and cheap, hovering at about 50 pence per therm between 2010 and 2021.
This changed in the summer of that year, with economies reopening as the coronavirus pandemic eased and Russia started to squeeze supplies. Prices then leapt after Russian troops poured over the border with Ukraine, surging as much as 11-fold to 640 pence per therm in August 2022.
By January 2023, Ofgem’s price cap, which usually governs how much a typical household pays and is reset every three months to reflect changing wholesale costs, had reached £4,279 per year — almost four times higher than in 2021.
By then the government had stepped in with a subsidy, known as the energy price guarantee, that limited the typical annual bill to £2,500 at an estimated cost to taxpayers of £29.4bn. But as the cap drops below that level most support for households will end.
Following a relatively mild winter and efforts across Europe to reduce demand, wholesale prices have fallen back but are still well above the prewar average.
What does this mean for bills?
The easing of wholesale prices meant Ofgem has lowered the price cap to £2,074 from July, and analysts at Investec predict it could fall below £1,900 in October, but that is still more than £750 above early 2021 levels.
Energy suppliers buy gas months and years in advance and forward gas prices remain above 110 pence per therm for the next three winters, before falling back to 92 pence in 2026, according to commodity analytics company ICIS.
These levels reflect continued uncertainty about supply and demand in Europe and tight gas margins globally. In turn, gas prices largely dictate the cost of electricity due to the critical role of gas-fired power stations in Britain.
Wholesale costs are the biggest component of energy bills, accounting for about 50 per cent of July’s price cap. The rest of the bill breaks down into elements such as suppliers’ operating costs and profit margin, subsidies for renewable generation and vulnerable households, and the cost of operating the gas and electricity grids.
The latter so-called network costs, which account for almost 20 per cent of July’s price cap, have risen by more than half since 2018. Although inflation has played a part, a big driver has been the higher costs for balancing electricity supply and demand, which has become more complicated due to the growing proportion of intermittent renewable power in the UK’s energy mix.
The electricity grid will also require significant investment in the years ahead to connect the growing number of wind farms that are being built and handle the anticipated increase in demand as households switch to electric cars and heat pumps, often referred to as the “electrification” of the economy.
Could competition among suppliers help?
Shopping around for a cheaper deal well below the default tariffs governed by the price cap — “switching” in industry jargon — was all the rage less than three years ago.
Spurred on by Ofgem’s efforts to boost competition, dozens of suppliers entered the market offering knockdown tariffs. But the energy crisis triggered a market rout with more than 30 suppliers collapsing under the weight of rising wholesale costs, which put an end to discounted fixed tariffs.
Analysts do not expect a return to the bargain deals after Ofgem took steps to ensure a more stable market and suppliers remain wary of further wholesale price surges or higher costs due to policy changes.
“Fixed price deals could return, most likely from the third quarter, but we do not expect a deluge of cut price deals,” said Martin Young, analyst at Investec. “We see switching driven by customer service and innovative products.”
What is the outlook for the second half of the decade?
Forecasting wholesale energy prices more than four years out is difficult. But analysts agree demand for electricity will rise as the electrification of the economy accelerates.
Recent modelling by consultancy Cornwall Insight predicts electricity prices will remain above £100 per megawatt-hour “until 2030 and likely beyond” — double historic norms.
While one driver will be higher domestic demand, another will be higher electricity exports to France as generation from the country’s fleet of ageing nuclear power stations falls, according to the analysis.
This would represent a reshaping of energy flows: Britain has historically been a net importer of electricity from France, apart from last winter when several French nuclear plants were closed for maintenance.
“We believe that [French nuclear reactor closures] will start happening in the late 2020s,” said Thomas Edwards, senior modeller at Cornwall Insight. “At the same time, we’ve got to put hydrogen, electric vehicles, heat pumps in — that’s all going to increase demand for electricity.”
But there is uncertainly around the future shape of the retail and wholesale markets with the government exploring a number of reforms. These range from consumers paying different prices depending on their proximity to generating capacity to special tariffs for less well-off households.
But “the devil is in the detail”, said Simon Virley, head of energy at KPMG. One of the big questions is how to fund a future social tariff. “Does the money come from taxpayers, or other energy bill payers?”
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